The cost of goods sold or “COGS” measures how much it costs a business to sell a product. Costs included in the calculation must be directly tied to the inventory sold. COGS is directly proportional to revenue and is often deducted from revenue to calculate gross profit.
What's included in COGS?
The direct costs associated with producing the goods or providing the services offered by the company. These costs may include:
- Variable costs involved in manufacturing products, such as raw materials, labor, and freight/shipping costs
- Fixed costs such as storage fees and factory overhead
What's excluded from COGS?
COGS does not include general selling expenses, such as management salaries and advertising expenses.
How do you calculate COGS?
The formula to calculate COGS is:
How do you apply this to your business?
First, determine the period of time to measure, for example, one month. Then determine your beginning inventory value and include any direct costs, such as materials, labor, shipping, and storage. Add additional inventory purchases made. Lastly, subtract the remaining inventory on hand at the end of the month.
Let's look at an example. In this scenario, you have sold 175 units at a unit cost of $3.
Over the period being measured you held a total of 250 units, 175 units were sold, making our ending inventory 75 units. Unit cost was derived using the weighted average method. How you determine the value of your inventory will depend on the inventory valuation method used.
Tip: Calculate your Gross Profit by subtracting your COGS from Revenue.
Methods for Calculating Inventory Costs: *
In order to calculate your COGS, you need to determine what counts as direct costs and which inventory valuation method to use for your business. This will then allow you to determine your unit cost. Your unit cost should be used as the COGS input in Flywheel.
Here are some widely used methods:
Weight Average: Specific costs for inventory is not used, instead it averages the total costs of goods sold divided by the number of available units.
FIFO: Inventory that is the oldest is being sold first. Costs in the COGS calculation will be assessed as the direct costs tied to the oldest inventory.
LIFO: Inventory that is the newest is being sold first. The most recent direct costs are used in the formula.
*These are mere recommendations meant for educational purposes only. Speak with an accountant to learn what is best for your business.